- The effects of overconfidence and herding bias on entrepreneurial performance in Ghana
We all have that one friend who calls us with a wild business idea, believing without an iota of doubt that it will make him/her a multi-billionaire. Only to realize that the idea and all investments made have been crushed within the first few years of business.
This might be a classic case of overconfidence bias. You have probably also heard someone quip, “ in Ghana, if one person starts producing bottled water, everybody else will follow suit”. This quip typifies herding behaviour.
Overconfidence bias and herding bias are forms of cognitive biases. Cognitive biases occur when individuals make decisions or judgments based on their experiences, emotions, individual preferences, and subjective perspectives. This means that you can take a decision that is entirely different from what is rationally expected of you in a situation due to your emotions, experiences, or personal preferences.
And in some cases, your choice might be different from the optimal choice. Like any other person, entrepreneurs experience emotions and have past personal experiences and preferences, making them susceptible to cognitive biases when making decisions that affect their business.
Considering that entrepreneurship contributes significantly to economic development, it is essential to understand how cognitive biases affect entrepreneurial performance. This article discusses the overconfidence and herding biases in relation to entrepreneurship.
Overconfidence bias is the failure to recognize the limitations of one’s knowledge, skills, and capabilities. It occurs when you believe yourself to be more competent than you actually are. An example of overconfidence is when you estimate that you will sell 1000 pairs of shoes as a shoe vendor, so you place an order for 1000 pairs of shoes from the manufacturer but end up getting only 250 orders from your customers. In this case, you would have overestimated your sales, locked up your capital, and incurred extra cost for storing the excess 750 pairs of shoes.
Entrepreneurs in developing countries are more prone to overconfidence bias because in our parts of the world, vital resources like data needed for business decision-making remain inadequate.
Overconfidence bias could cause an entrepreneur to make a fatal business decision. The likelihood of business failure occurs because overconfidence bias motivates entrepreneurs to mistake short-term opportunities for long-term opportunities. As they commit their resources, funds, and time to short-term opportunities that are not sustainable, they tend to lose sight of the more sustainable long-term business opportunities.
While the long-term investments are completely neglected or under-resourced, the short-term investments do not bring profits worth the investments. Suffice to say, investing in a business opportunity that does not yield adequate profit and underfunding a profitable business opportunity are recipes for failure.
Now, let’s turn the spotlight on herding bias. Imagine you moved into a new neighborhood, with no prior knowledge of the quality of food or service of restaurants in the area. In which of the two restaurants would you purchase food for lunch?
- Option 1: A very busy restaurant with lots of customers
- Option 2: An idle restaurant with relatively fewer customers
If you chose option 1, then you are probably experiencing herding bias. Herding bias occurs when individuals make their decisions copying the action and choices of others. It usually occurs because of limited access to data and information. Although some might argue that herding can be considered as a hedging strategy, entrepreneurs should be wary of herding because copying the actions and decisions of others could cause them to limit their innovation and creativity, and prevent them from differentiating their products. Overconfident entrepreneurs are less likely to herd as they tend to believe that their ideas are superior to others. This worldview prevents them from copying the ideas and actions of others blindly.
That notwithstanding, some quick-witted entrepreneurs harness a popular business idea to gain massive profits given that they know when to pull out their capital or move on to a more sustainable business model or idea. A perfect example of this scenario would be how the onset of the Covid 19 pandemic saw some retail and wholesale traders investing heavily in items such as face masks, hand-sanitizers and face-shields. At the peak of the pandemic, one face-shield was sold for GHS 50 but about a month or two into the pandemic a face-shield sold for as low as GHS 1.
Entrepreneurs who got into the business of selling face-shields later ran at huge losses because there was excess supply and little demand for them. This could be a classic case of herding and overconfidence at play. Sometimes, in learning and copying the business decisions of a successful group of entrepreneurs upcoming entrepreneurs are afforded a blueprint to build more successful businesses. However, some of these upcoming entrepreneurs may not have adequate information, resources and experience so they blindly copy trending business ideas without innovating them.
It is clear that entrepreneurs, like any other person, face some cognitive biases in decision-making that might affect their businesses’ performance and survival. Therefore it is only right for them always to keep themselves in check and make conscious efforts to avoid psychological biases. A little bit of these biases will not hurt their businesses anyway. A little bit of overconfidence will give an entrepreneur the extra push needed to grab an opportunity after making some analysis while herding bias will enable an entrepreneur to identify new trends.
However, if entrepreneurial business decisions are mainly driven by cognitive biases rather than sound data and market analysis, we might be in trouble as a nation. The onus lies on entrepreneurs to be aware of these biases when making major business decisions so as to strive to make sound data-driven decisions or seek professional assistance if they lack the know-how. It also behoves the government to create a conducive business environment where such support services are accessible and affordable.
The authors are with Ashesi University